Whether To Refinance Mortgage Or Pay Down Existing Loan

Q: We want to refinance our home loan. We are at 5.75 percent and might be able to get 4.85 percent on a 30-year fixed-rate mortgage. We will save between $87 to $104 dollars per month and we are thinking about adding extra money each month to pay off the loan faster.

With a 30 year loan, I’d pay twice a month and add extra toward the principal each month, because you never know about this economy. Please give me your opinion.

A: There are four important questions to ask yourself before starting a refinance:

1. Will I lower my interest rate? From your email, it’s clear that you meet this test.
2. Will I lower my monthly payment? You’ll save money each month.
3. Will I shorten my loan term? This is an important question because if you have only 25 years left on your loan and are starting up with another 30-year loan, you’ve essentially lost five years of payments. But if you have 25 years left and can refinance to a 15-year mortgage, you’ll come out ahead.
4. What are the costs to refinance? If a lender will charge you so much that it’ll take years to pay off the costs of the refinance with your monthly savings, it may not be worthwhile to refinance.

Of these four questions, the biggest issue is how much time you have left on your loan. In your case, it sounds as though you have enough room to refinance to a 15-year loan. If your monthly payment is less with a 15-year loan, and you can use that savings to prepay the loan further, then you know you’re making a smart move.

But it isn’t really fair to compare monthly payments when a new loan is going to add years of payments. You must also compare what the costs are to close the loan.

The best way to lower the costs on a refinance is to shop around. Talk to at least four or five different types of lenders: A credit union (if you belong to one or can join one); a big box lender (like Chase, Sun-Trust, Wells Fargo, Citibank, or Bank of America); a local mortgage broker; an Internet lender (like ING Direct) or a mortgage aggregator; and a small, local bank that might keep loans in its own investment portfolio.

Before you call any of the lenders, visit AnnualCreditReport.com and get a free copy of your credit history and pay for a credit score. If your credit score is less than 660 or 680, you may not even qualify for an FHA loan, so your time would be best spent cleaning up your credit.

If your credit score is good, then be sure to share that information with lenders. Tell them, “I know you have to pull your own copy of my credit history and score once I officially apply for the loan. But assume this is current. What kind of interest rate, points, fees, etc. would I qualify for?”

Finally, if you do make extra payments to pay down your loan, don’t forget to indicate on your payment that you made an extra payment to be applied towards the principal on your loan. If you have an escrow account for the payment of real estate taxes or insurance, and you don’t specifically say that the extra is to be used to pay down the loan balance, you might be surprised to find out that your extra payments went into the escrow account and not to pay down your debt.

For more information on refinancing a mortgage or reducing your mortgage payments, see the following articles: